Why Are ETFs So Cheap?

The first thing people talk about when they talk about ETFs is their low fees. And it’s true: While the average U.S. equity mutual fund charges 1.42% in annual expenses, the average equity ETF charges just 0.53%. If you look at where the bulk of ETF money is actually invested, the average fee is an even-lower 0.40%.

And you can get lower—much lower—than that. At ETF.com, we’ve created a well-diversified model portfolio of ETFs—complete with U.S. stocks, international stocks, emerging market stocks, bonds and commodities—with a blended average expense ratio below 0.09! That’s $9 for every $10,000 invested.

Try doing that with mutual funds.

More Efficient Than Mutual Funds

ETFs are cheaper than traditional mutual funds for many reasons. For starters, most ETFs are index funds, and tracking an index is inherently less expensive than active management. But index-based ETFs are even cheaper than index-based mutual funds. So what gives?

It comes down to the way mutual funds and ETFs relate to their investors.

How A Mutual Fund Works

When a mutual fund receives a “buy” order from a new investor, it has a lot of work to do. First, it must process the order internally, recording who it was that entered the buy order and how much money was deposited with the firm. The fund company must then send out confirmation documents, and handle any compliance issues. Then, the mutual fund’s portfolio manager must go into the market and invest that money, buying and selling securities and paying all the necessary spreads and commissions involved.

When investors sell, the process works in reverse. Managers sell; funds get disbursed; and so on. It’s a lot of hands-on management—and paperwork—and it ends up costing the fund a lot of money (which it passes along as higher fees).

With ETFs, it’s easier. When investors want to buy shares of an ETF, they simply enter an order with their brokerage and … that’s it.

For most investors, ETF trades take place with other investors, and not with the fund company itself. That means the fund company doesn’t have to process your order; doesn’t have to mail you the same documents; and doesn’t have to go into the market to process your order.

Less work = lower costs. Point 1 in ETFs’ favor.

But how do ETFs actually invest money in the market if they have limited interactions with individual investors?

The answer to that lies in something called the “creation/redemption” process, which is the key to understanding how ETFs function.